IR35: The Backdrop: 

In the UK, HM Revenue and Customs (HMRC) – which is the tax collecting department of the UK Government – has set out to deal with a growing challenge, being that the distinction between being an employee versus being an independent contractor (or self-employed) has become increasingly blurred.  

HMRC believed that some companies were using this ambiguity to incorrectly classify many workers as self-employed for tax avoidance purposes, while some self-employed workers were also benefiting from paying lower tax rates than they should have. 

 IR35 legislation is HMRC’s answer to this challenge. The end-goal is to make sure companies comply by correctly distinguishing between their employed and self-employed workforces. 

We want to make it clear that both ‘employed’ and ‘self-employed’ are still perfectly viable options for businesses and workers in different scenarios under IR35, but they need to be managed correctly in order to avoid potentially falling foul of the new regulations. 

Our thesis on IR35 is that HMRC is likely to take a positive view of businesses that have tried to do the right thing in IR35 implementation, have gone through a suitable due diligence process and have implemented any required changes. They refer to this as reasonable care within the legislation.

In fact, we would even expect that any excess taxes previously paid, that have been identified as unnecessary, could be deducted from future taxes owed.  

It is the job of experts in this field, such as Briars, to guide businesses through this process.

The challenge:

Where IR35 becomes difficult for many businesses – particularly in the age of the gig-economy – is that it can be genuinely hard to distinguish between employed and self-employed workers.

Nonetheless, IR35 is a critical piece of legislation that businesses operating in the UK must understand and comply with.

Officially known as the Intermediaries Legislation (IR stands for ‘Inland Revenue’), IR35 affects both contractors and the companies that engage them, bringing forth a paradigm shift in how employment status is determined and taxed within the realm of contracting.

Introduced by HMRC in 2000, IR35 seeks to identify ‘disguised employment’ situations where individuals work as contractors through an intermediary, such as a personal service company, but their working conditions and relationship with the client mirror that of an employee. This is important, as being classed as ‘self-employed’ in the UK can attract a lower level of tax than being ‘employed’.

The essence of IR35 is to ensure that contractors who essentially fulfil the role of employees, albeit through a corporate veil, pay similar taxes and National Insurance contributions as their employed counterparts, as well as insuring those who are truly self-employed are able to engage as an independent contractor and provide flexible benefits to their clients.

Where IR35 Comes In:

The significance of IR35 cannot be understated for businesses. Its implications stretch far beyond the administrative; it reshapes contractual engagements, influences financial planning, talent strategies and necessitates a thorough understanding of compliance requirements.

With changes and updates to the legislation, especially the 2017 and 2021 reforms shifting the responsibility of determining IR35 status from contractors to the medium and large businesses that hire them, it has become imperative for all parties involved to grasp the nuances of IR35 fully.

Meanwhile, any notions that IR35 will simply go away should not be taken seriously. The legislation has evolved over the years and will be fully implemented, and the principle is mirrored in most countries around the globe.

For us, the key is to help our clients understand how they can still make the most out of a flexible workforce.

Whether you are a business owner, HR professional, or financial advisor, understanding IR35 is crucial for ensuring that your engagements with contractors are both productive and compliant, safeguarding your business against potential penalties and fostering a transparent, fair working environment for all.

A Guide for Businesses:

In the below sections, we will aim to cover the main challenges of IR35, as well as how businesses should prepare for this legislation. 

What is IR35?

IR35, formally known as the Intermediaries Legislation, is a pivotal tax legislation enacted in the UK by HM Revenue and Customs (HMRC) in April 2000. Its primary purpose is to combat tax avoidance by contractors and businesses that engage them, ensuring that individuals who work in a similar manner to employees pay comparable taxes and National Insurance contributions, regardless of the structure through which they operate.

This legislation is critical for anyone engaged in contract work or hiring contractors to understand, as it directly impacts how employment relationships are classified and taxed.

At the heart of IR35 is the concept of ‘disguised employment.’ This term refers to situations where individuals work for a client through an intermediary (like their own limited company) but have working conditions and relationships that resemble those of an employee rather than an independent contractor. IR35 seeks to identify these situations and ensure that such workers pay tax and National Insurance contributions as if they were employed directly by the client, effectively closing the tax loophole.

We would reemphasise that IR35 isn’t going to stop businesses from taking advantage of the flexibilities of self-employed workers, but rather to put an end to situations in which some companies are simply trying to avoid tax liabilities.

How does HMRC define self-employment?

The HM Revenue and Customs (HMRC) definition of self-employment is pivotal in understanding the IR35 legislation and its implications. HMRC does not provide a single definition of self-employment; instead, it considers a range of factors that characterise a self-employed individual’s working arrangement. These factors collectively determine whether a person is self-employed for tax purposes.

What does being ‘inside IR35’ mean?

When a contractor is deemed to be ‘inside IR35’, it signifies that the contractor is considered an employee for tax purposes and therefore subject to PAYE (Pay As You Earn).

This classification has significant tax implications for both the contractor and the hiring organisation, but those are not insurmountable with the help of experts in this area.

‘Employee’ for Tax Purposes:

Being ‘inside IR35’ means HM Revenue & Customs (HMRC) views the contractor as if they were directly employed by the client, based on the working practices and conditions of their contract. It suggests that the contractor, if not for the intermediary (like their own limited company), would be indistinguishable from an employee.

What does being ‘outside IR35’ mean?

When a contract is described as being ‘outside IR35’, it indicates that the engagement is considered to be one of genuine business-to-business service provision, rather than disguised employment. Being outside IR35 has significant tax implications for contractors and the hiring businesses, as it affects how the contractor is paid and how taxes are handled.

Why Being Outside IR35 Matters:

Being classified as outside IR35 is often financially beneficial for contractors, as it allows for more tax efficiency in the way they pay themselves. For businesses, it reduces the administrative burden of tax deductions and reporting responsibilities associated with employees.

However, it’s crucial that this status accurately reflects the reality of the working arrangement. Misclassifying a contract as outside IR35 when it should be inside can lead to significant penalties from HMRC. To ensure compliance, both the written contract and the actual working practices must be consistent with an independent contractor relationship.

Determining IR35 status can be complex and should be approached carefully. It’s often advisable for both businesses and contractors to seek expert advice or use HMRC’s Check Employment Status for Tax (CEST) tool to aid in making an accurate assessment.

Briars has a large amount of experience in helping businesses to distinguish between ‘employed’ and ‘self-employed’ workers, as well as dealing with the consequential operations around making these classifications.

What makes a contractor different from an employee?

Understanding the distinction between a contractor and an employee is fundamental when dealing with IR35. Both play different roles within businesses, and the distinction has significant legal and tax implications.

Control Over Work:

Contractors typically retain control over how they complete their tasks. They may choose when and where they work and how they go about completing a project, within the terms of their contract.

Employees, on the other hand, are usually subject to a higher degree of control by their employer, who directs when, where, and how their work should be done.

What are the recent changes to IR35?

The IR35 legislation has undergone significant changes in recent years to address concerns about compliance and enforcement. These changes have been some of the most substantial in the legislation’s history and have a profound impact on how businesses engage with contractors.

2017 Public Sector Reform

The first major change came in April 2017 when the government reformed the IR35 rules for the public sector. Previously, it was the responsibility of the contractor’s intermediary (usually their personal service company) to determine the contractor’s employment status for each contract. However, the reform shifted this responsibility to the public sector body engaging the contractor.

This meant that public sector clients were now responsible for determining whether the contractors they hire fall inside or outside of IR35.

If the contract is deemed to be inside IR35, the entity that pays the contractor’s company must deduct income tax and National Insurance contributions as they would for an employee.

2021 Private Sector Reform

On 6 April 2021, similar changes were rolled out to the private sector, particularly affecting medium and large businesses. The key aspects of the reform include:

• The end client is responsible for determining the IR35 status of a contract.

• The ‘fee-payer’ (the party paying the contractor’s company) must handle tax and National Insurance deductions if the contract is inside IR35.

• Small companies are exempt from these changes, meaning the responsibility for determining IR35 status remains with the contractor’s intermediary.

Definition of a Small Company:

To be exempt from the new rules, a company must meet two or more of the following criteria for two consecutive financial years:

• An annual turnover of not more than £10.2 million.

• A balance sheet total of not more than £5.1 million.

• No more than 50 employees.

Additional Changes:

Introduction of the Status Determination Statement (SDS): The client must provide an SDS for each contract, stating whether it falls inside or outside IR35 and the reasoning behind the determination.

Dispute Resolution: A client-led disagreement process was introduced, allowing contractors and fee-payers to challenge the status determination.

Impact of the Changes:

These reforms have placed a significant administrative and financial burden on clients who engage contractors. Companies now need robust systems to assess contracts accurately, and contractors are more reliant on clients’ understanding of IR35 to determine their tax status. Moreover, these changes have led to a cautious approach from many businesses, with some opting to classify all contractors as inside IR35 to avoid potential penalties.

Who do the IR35 rules apply to?

IR35 rules are designed to assess whether contractors are working in a manner that is genuinely self-employed, or whether they are, in fact, ‘disguised employees’ for tax purposes. These rules apply to:

Contractors:

This includes individuals who provide their services through an intermediary, usually a personal service company (PSC), but also through partnerships or managed service companies. The rules are in place to determine if these individuals should be taxed in the same way as employees based on their working practices, not just what is written in their contracts.

Private Sector Clients:

As of April 2021, the responsibility for determining the IR35 status of a contract shifted from contractors to all medium and large-sized private sector clients. This means that these businesses must now assess whether the contractors they hire are inside or outside IR35.

Public Sector Clients:

Public sector authorities have been responsible for assessing the IR35 status of their contractors since April 2017. They must also determine if the off-payroll working rules apply and are responsible for deducting taxes and National Insurance contributions accordingly.

Agencies:

Employment agencies or third parties that provide contractors to clients are also affected by IR35 rules. Where a public or private sector client determines that IR35 applies, the agency that pays the contractor’s intermediary is responsible for deducting taxes and National Insurance contributions.

Who is exempt from IR35?

Small businesses are exempt from the need to determine the IR35 status of their contractors. Instead, the responsibility remains with the contractor’s intermediary, as was the case before the 2021 reforms. A small business is defined by meeting two or more of the following criteria: an annual turnover of not more than £10.2 million, a balance sheet total of not more than £5.1 million, and/or not more than 50 employees.

It is important to note that while IR35 legislation applies to the intermediaries providing the services, it is the end clients (and sometimes agencies) who have the obligation to conduct the status determinations under the current rules. These entities must carry out due diligence to determine the employment status of each contract and communicate their decision to all parties involved in the supply chain. Failure to comply with the rules can result in financial penalties and back taxes being owed.

IR35 rules do not apply to the employment status of workers who are directly employed by a client, as their taxes are already handled through PAYE. It is also not concerned with workers who are genuinely self-employed without using an intermediary or who are sole traders working directly with their clients; in these cases, different tax rules apply.

In essence, IR35 targets specifically the tax treatment of off-payroll workers to ensure that individuals who work like employees, but through their own company, pay taxes in a similar way to ‘on the payroll’ employees.

Does IR35 apply to limited companies?

IR35 can apply to limited companies, specifically in cases where such companies are used as intermediaries by individuals to provide services to clients. These are often referred to as Personal Service Companies (PSCs).

For medium and large companies, as well as public sector organisations, it is the client’s responsibility to determine the IR35 status of the contractors they hire. If the rules are deemed to apply, the fee payer (which could be the client or an agency) is responsible for deducting the correct tax and National Insurance.

For small companies, the contractor’s limited company continues to be responsible for determining the IR35 status of each contract.

Importance of Accurate Assessment:

It’s crucial for both contractors and the companies that hire them to accurately assess the IR35 status of their working arrangements. Incorrectly determining that IR35 does not apply when it does can result in substantial back taxes, interest, and penalties.

Can IR35 impact an Employer of Record (EoR)?

The simple answer is no, but it’s rarely that simple. Many businesses and individuals have been caught out by non compliance and entities asserting employment taxes have been deducted when they have in fact not. The issue tends to be the terms EOR, AOR, Umbrella and PEO are interchanged with no statutory definition.

Definition of an Employer of Record:

An Employer of Record (EoR) is a third-party business that acts as an employer to contractors who work under temporary contract assignments. The EoR enters into a contract with the business (or sometimes directly with the end client), and the contractor becomes an employee of the EoR.

This is useful for businesses who want to expand overseas, or into the UK market, as it allows them to quickly build a local workforce with the help of the EoR.

It can take a significant amount of time for a business to enter a new market and set up the correct workforce and tax frameworks, so hiring an EoR is an effective temporary solution to quickly gain market entry.

Briars has acted as an EOR on behalf of many clients who have expanded to the UK and in other global markets.

IR35 and EoRs:

IR35 rules are designed to apply to contractors operating through their own personal service companies (PSCs) and not to employees. Because contractors working through EoRs are classified as employees of the EoR, IR35 does not apply in the same way it does for PSCs.

The Key Differences:

Tax Treatment: When working through an EoR, the contractor is treated as an employee for tax purposes. The EoR deducts income tax and National Insurance contributions before paying the contractor, similar to any other employment situation.

Employment Rights: Contractors gain employment rights, including sick pay, holiday pay, and access to a pension scheme, because of their employment status with the EoR.

Administrative Burden: The EoR handles the administrative tasks related to employment, such as payroll, tax deductions, and invoicing the agency or client.

Compliance and Benefits:

IR35 Compliance: By working through an EoR, contractors effectively sidestep the complications associated with IR35 legislation. They don’t need to worry about proving their employment status for tax purposes, as the compliance responsibility lies with the umbrella company.

Simplification: For many contractors, using an EoR simplifies the process of contracting, as they do not have to deal with the administrative workload that comes with running a PSC, including IR35 assessments and potential disputes with HMRC.

Impact of IR35 on Businesses:

The IR35 legislation has profound implications for businesses engaging contractors. Its reach extends from financial aspects to compliance obligations and strategic workforce planning. Here is a broad overview of the areas affected by IR35 within a business context.

Financial Impact

Tax Liabilities: Businesses must assess whether their contractors fall inside IR35. If they do, businesses, or the agencies they work with, may need to deduct income tax and National Insurance contributions, as if these contractors were employees.

Increased Costs: The additional tax liabilities can lead to higher costs for businesses. They may also face increased administrative expenses related to assessing and ensuring compliance with IR35. Large users of the flexible workforce have had to hire full time employees to manage the operational overhead of managing compliance.

Budgeting and Planning: Companies must account for the potential increase in labour costs in their financial planning and budgeting, as the costs of engaging contractors who fall inside IR35 will likely rise.

Administrative Burden

Assessment Procedures: Determining the IR35 status of contractors requires a thorough evaluation process, which includes record-keeping and administering Status Determination Statements (SDS).

Payroll Adjustments: For contractors deemed inside IR35, businesses must adapt their payroll systems to handle tax and National Insurance deductions.

Compliance and Legal Obligations

HMRC Investigations: Businesses must be prepared for HMRC audits and ensure their IR35 determinations are accurate. Non-compliance can result in significant fines and back payments.

Dispute Resolution: Implementing processes to deal with disagreements over IR35 status determinations is essential, as contractors can challenge their assessments.

Recruitment and Contracting

Contract Reviews: Existing contracts with contractors may need to be reviewed and potentially renegotiated to ensure they reflect the true nature of the working relationship in the context of IR35.

Attraction and Retention: The IR35 status of a role can influence a contractor’s decision to take on a project, affecting a business’s ability to attract and retain the best talent.

Strategic Workforce Considerations

Employment Structure: Businesses might need to reconsider their employment structures, potentially shifting from contractor-based models to fixed-term or permanent employees where IR35 applies. This could lead to employers being unable to attract the top talent as their proposition is unattractive from a tax position.

Resource Allocation: There may be a strategic shift in how businesses allocate resources, with a possible move towards outsourcing to third-party firms where IR35 is not a factor.

Market Dynamics

Competitive Edge: Companies that effectively manage IR35 can have a competitive advantage, as they can offer clarity and stability to contractors while ensuring cost-effective engagement strategies.

Sector Variations: The impact of IR35 can vary across different sectors, with industries heavily reliant on contractors, such as IT and engineering, being particularly affected.

Implementing IR35:

The introduction and enforcement of IR35 have required businesses to undertake comprehensive reviews of their workforce arrangements and contractual practices. These changes have led to increased operational demands and a need for heightened vigilance in managing tax compliance.

In adapting to IR35, businesses must balance the necessity of compliance against the flexibility and expertise that contractors bring to their operations. The impact of IR35 is an ongoing concern that requires businesses to remain agile and informed in their approach to engaging contract labour.

Nonetheless, we believe that the market overreacted initially to IR35 announcements, leading to many industries stopping all engagement with independent contractors, which restricted their ability to access talent.

Now the recent IR35 changes have had time to bed in, forward-thinking businesses are engaging their workforce across employees directly, through and EOR and also accessing talent by engaging directly with independent contractors by implementing robust compliance systems.

If you would like more information on how to implement required changes for IR35 and properly classify your workforce, Briars stands ready to share our vast expertise in this area. Get in touch now for a consultation.

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Frequently Asked Questions (FAQs) About IR35

Q: What exactly is IR35?

A: IR35 refers to the UK’s anti-avoidance tax legislation designed to tax ‘disguised employment’ at a rate similar to employment. In other words, it ensures that contractors who work like employees but through their own company, pay similar taxes to regular employees.

Q: How do I determine if IR35 applies to a contract?

A: To determine if IR35 applies, you must consider factors like control, substitution, financial risk, and the nature of the working relationship. HMRC’s Check Employment Status for Tax (CEST) tool can also help with this assessment – however we always recommend engaging an expert rather than a DIY approach with CEST.

Q: Who is responsible for determining IR35 status?

A: Since April 2021, all public sector authorities and medium or large-sized private sector clients are responsible for determining the IR35 status of the contractors they hire.

Q: What are the consequences of getting IR35 status wrong?

A: Incorrectly determining IR35 status can lead to back taxes, interest, penalties, and fines. It is important to make an accurate assessment to avoid potential liabilities.

Q: Can I challenge an IR35 determination?

A: Yes, contractors and firms can challenge an IR35 determination if they believe it is incorrect. It is recommended to provide evidence to support the reasoning for the challenge.

Q: Does IR35 apply to all businesses?

A: No, small businesses are exempt from determining the IR35 status of their contractors. The contractor’s intermediary is responsible for IR35 in these cases.

Q: How can businesses ensure compliance with IR35?

A: Businesses should conduct thorough assessments of their contracts, keep detailed records of their determinations, and stay informed on IR35 legislation. Consulting with legal or tax professionals is also advisable.

Q: Can IR35 apply to contracts with work done outside the UK?

A: IR35 can still apply even if the work is carried out abroad. The key consideration is whether the worker would be an employee if directly contracted.

Q: Will IR35 affect the cost of hiring contractors?

A: Potentially, yes. If a contract falls inside IR35, the additional tax and National Insurance contributions can increase the overall cost of engaging contractors.

Q: How does IR35 affect payroll?

A: For contracts inside IR35, businesses must deduct income tax and National Insurance contributions as they would for an employee, which requires payroll adjustments.

Q: Are there any benefits to being inside IR35?

A: While being inside IR35 is less tax-efficient for contractors, it can provide employment rights and benefits similar to those of an employee.

Q: Can I still work through a personal service company (PSC) despite IR35?

A: Yes, but the way income is taxed through the PSC will depend on whether the contract is inside or outside IR35. It’s crucial to assess each contract accurately.

Remember, IR35 is complex, and each case can be unique. It’s always best to seek expert advice if you’re unsure about your situation or the IR35 status of a contract.